Congress Heeds SEC's Call for Regulation of Credit Default Swaps

In the wake of a call by SEC Chair Christopher Cox for the regulation of credit default swaps, Senator Tom Harkin will introduce legislation regulating swaps and other financial derivatives that are currently traded with virtually no regulation or transparency. Senator Harkin, chair of the Agriculture Committee, noted that, while swaps contracts function much like futures contracts, they are not regulated as futures contracts because of a statutory exclusion from CFTC authority. Since they do not have to be traded on open, transparent exchanges, it is impossible to know whether credit default and other swaps are being traded at fair value or whether institutions trading them are becoming overly leveraged or dangerously overextended. Financial derivatives like credit-default swaps must be traded on a regulated exchange, said the senator, so that regulators can know the value of the contracts, who is trading them, and if they have enough assets to back the contract.

According to Director of Market Regulation Eric Sirri, the SEC has a great interest in the credit derivatives market because of its impact on the debt and cash equity securities markets and the Commission's responsibility to maintain fair, orderly, and efficient securities markets. In testimony before the House Agriculture Committee, he said that these markets are directly affected by credit default swaps due to the interrelationship between the swap market and the claims that compose the capital structure of the underlying issuers on which the protection is written. In addition, the SEC has seen credit default swap spreads move in tandem with falling stock prices, a correlation suggesting that activities in the OTC credit default swaps market may be spilling over into the cash securities markets.

The Commission's current authority with respect to these instruments, which are generally security-based swap agreements under the CFMA, is limited to enforcing antifraud prohibitions under the federal securities laws. The SEC is prohibited under current law from promulgating any rules regarding credit default swaps in the over-the-counter market. Thus, the tools necessary to oversee this market effectively do not exist.

OTC credit derivatives emerged in the mid-1990s as a means for financial
institutions to buy insurance against defaults on corporate obligations. Credit default swaps are executed bilaterally with derivatives dealers in the OTC market, which means that they are privately negotiated between two sophisticated, institutional parties. They are not traded on an exchange and there is no required recordkeeping of who traded, how much and when. Although credit default swaps are frequently described as buying protection against the risk of default on, for example, corporate bonds, they are also used by investors for purposes other than hedging. Institutions can and do buy and sell credit default swap protection without any ownership in the entity or obligations underlying the swap. In this way, credit default swaps can be used to create synthetic long or short positions in the referenced entity.

Mr. Sirri cautioned that, in crafting any regulatory solution, it is important to keep in mind the significant role credit default swaps play in the financial markets, as well as the truly global nature of that market. Further, the varied nature of market participants and the breadth of this market underscore the importance of cooperation among U.S. and global regulators.

In earlier testimony before the Senate Banking Committee, Chairman Cox said that the credit derivatives market is a regulatory hole that must be closed by Congress. The $58 trillion notional market in credit default swaps is regulated by no one, he emphasized, and neither the SEC nor any regulator has authority over this market. He described a credit default swap buyer as tantamount to a short seller of the bond underlying the swap. Since credit default swap buyers do not have to own the bond or other debt instrument upon which the swap contract is based, they can naked short the debt of companies without restriction. As part of the fundamental reform of the financial system, Congress must provide statutory authority to regulate these products.